"A false or mistaken idea based on faulty knowledge or reasoning." This is how the American Heritage Cultural Dictionary defines the word 'fallacy.'
The subject of common fallacies and biases as they relate to investing is both interesting and important. It should be of interest if you are an investor because it is likely that you and I are making important investment decisions based on both "faulty knowledge" and/or "reasoning."
Therefore, in this article I will give some examples of common fallacies and a bias we see and hear everyday in both website and newspaper articles, as well as on the TV financial networks. Which fallacies and/or biases have you based your investing decisions on?
1. Ad hominem. This is Latin for "to the man." This refers to an attempt to discredit someone by attacking him or her instead of the argument. A good example is a recent exchange I had here with one of the regular posters on that forum.
I had referred to a recent SA article by James A. Kostohryz titled: "U.S. Stocks Not in A Bubble," which you can read here. The individual on the aforementioned site resorted to ad hominem by making light of Mr. Kostohryz style of dress in his "contributor" photo. That individual wrote this about Mr. Kostohryz:
"You are correct that I have not offered any rebuttal to the above article (Mr. Kostohryz's article). I really did not want to waste my time, since I have other things which I enjoy doing besides reading articles on an already overvalued market....Everyone has advice, and I just do not think I can take a person serious that is dressed in play clothes." (Italics mine).
Did you catch the 'ad hominem?' Now, ask yourself how many times you have seen or heard this type of fallacy used. This is completely faulty reasoning. The factualness of a person's viewpoint is not related, at all, to his style of dress in a photograph. Or is it? If I were sitting in my underwear as I write this article, what effect would it have on whether what I write is worthy of your consideration or not?
2. Hasty generalization. The above individual also used this fallacious method in the very same paragraph he used 'ad hominem." He wrote: "I have other things which I enjoy doing besides reading articles on an already overvalued market..."
You'll notice that there is no effort made to support the statement that the market is "already overvalued." In fact, even after reading Mr. Kostohryz's article, where he clearly provides examples of well-known companies whose stocks are certainly not overvalued, this reader still uses the 'hasty generalization' fallacy.
3. Cherry picking. This refers to the act of pointing to individual cases or data that seem to confirm a particular position, while ignoring a significant portion of related cases or data that may contradict that position.
Interestingly, Mr. Kostohryz refers to this common fallacy in the article I have referred to when he says:
"Cherry picking high P/Es as a method of "analysis" does not work either. One article I read a few weeks ago claimed that US large caps were a bubble based on citing three or four stocks with P/Es in the high teens and the low 20s. But if you objectively survey the largest 50 US stocks by market capitalization, less than 25% have forward P/Es of over 15. And less than 10% have P/Es of over 20."
4. Confirmation bias. This is the tendency for people to only seek out information that conforms to their pre-existing viewpoints, and subsequently ignore information that goes against them. And even if people expose themselves to alternative points of view, it may still be a form of confirmation bias; in that they want to confirm that the opposing viewpoint is wrong.
We all have this tendency and it's constructive for you and I to be aware of this tendency so that we can combat it. Otherwise, we may end up making poor investment decisions based on our biases.
We see this bias amongst gold bulls/bugs. They claim that, based on the economic fundamentals, the price of gold should be much higher than it currently is and there is no logical reason to be invested in the conventional stock market, e.g. the S&P 500 or the DOW.
Unfortunately for them and the people who listen to them, they have been dead wrong over more than the past two years. See the below chart of the S&P 500 Large Cap Index. Those who have been invested in the conventional market have been in the 'correct' market and have made great returns on their invested capital.
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Now let's look at the results if you had stayed invested in the precious metals miners.
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Now, you tell me which you would have rather been invested in over the last two years or so. Where would you say the 'smart' money was invested?
Now, please don't misunderstand my point here. I am not suggesting that there won't be a time to take money out of the conventional markets and put it back into the miners. However, my point in this article is to illustrate that fallacies and biases can cause, even intelligent people, to make investment decisions that may cause them to lose out on great returns while keeping their money in investments that are going nowhere, or worse yet, going down.
What has happened over the past two years with the conventional stocks and the mining stocks is proof of this.
Beware of fallacious reasoning and biases, as they certainly can negatively affect your decision making process.